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CORRECTED-Stern Advice-Should you be running to or from munis?

Linda Stern
Wednesday, 18 Dec 2013 | 5:53 PM ET

(Corrects explanation of tax treatment of Treasury bonds in 8th paragraph, to show exempt from state taxes, not federal)

NEW YORK, Dec 18 (Reuters) - I'm a contrarian. So when I see investors fleeing municipal bond mutual funds at a record pace, and when I hear that it is nothing but risk, risk, risk for munis, I start looking for that silver lining.

After all, the secret of successful investing is to "buy when there's blood on the street," as Baron Rothschild liked to say.

Certainly, tax-exempt municipal bond funds are bloodied. They gave up $35 billion in net outflows in the third quarter of the year - and cashed out another $1.9 billion in net investments last week alone, according to figures from Lipper, a Thomson Reuters company.

Fleeing investors have had good reasons to run. For starters, they have lost money this year. Long-term muni funds have shed 4.47 percent of their investors' money in the year to date through Dec. 16.

So, some investors are just taking their money out and investing in stocks instead - that 25 percent return recorded so far by the Standard & Poor's 500 stock index is hard to ignore. Others are selling to take capital losses they can use to offset taxable gains.

Then, there are all those risks: With Detroit declaring bankruptcy and Puerto Rico gathering troubles and downgrades, investors worry that they could lose the money they put into these bonds. The idea that the Federal Reserve will allow interest rates to rise has investors stepping back from all kinds of long-term bonds: If rates rise, the value of the bonds they are holding will fall.

Heap on the possibility that Congress will devalue the tax benefits accorded munis when it finally does some kind of tax reform, and it is no wonder the whole market has been a big goodbye.

On the other hand, the overall economic health of state and local governments has been improving, so defaults should become less of a worry. And the interest on muni bonds - exempt from federal income tax and sometimes, from state income tax too - is tasty. Right now you can buy top-rated AAA 10-year munis yielding 2.7 percent - the equivalent of a 3.9 percent taxable yield if you're in the 28 percent federal/6 percent state tax bracket. Treasuries (exempt from state but not federal taxes) are yielding 2.9 percent for the same maturity.

Other reasons to buy munis?

They don't correlate to stocks, and in the year following a stock market blow out, you may want that lack of correlation.

Furthermore, munis are less volatile than Treasuries in a rising rate environment, says specialist Dawn Mangerson, vice president and senior portfolio manager with McDonnell Investment, a unit of Natixis Global Asset Management. "Munis are so cheap," she told reporters at a recent outlook meeting.

Long-term munis with 10 or more years to run on their maturity now are priced 0.60 percentage points over Treasuries - the widest spread in 18 months and up from 0.28 percentage points in mid June, according to Bank of America's Merrill Lynch index data.

Here are some ways to cautiously approach a market that might be done bleeding soon.

FIRST, SELL

Check your municipal bond holdings for losses; if you've got any, take them now. Even though the interest on them is tax-exempt, the gains and losses you record by buying and selling munis still are subject to capital gains taxes. You can buy different issues right away - or -if you have a particular muni fund you like, wait 30 days before you buy it back to avoid violating tax rules.

DO THE MATH

The more you make - and the higher taxes are in your state - the better munis are for you. That same 2.6 percent tax-free yield mentioned above would be worth 5.61 percent a year to a Californian (tax rate 12.3 percent)in the top 39.6 percent federal income tax bracket. Furthermore, muni interest also will not be subject to the new 3.8 percent investment income surtax hitting any single person who earns over $200,000 (or $250,000 for couples).

CONSIDER QUALITY

Just as all real estate is local, so are all muni issues. Some cities and states have large pension liabilities that could cause them to default on their obligations down the road.

Others are very much in the black. If you're going to be buying individual issues, "the first thing to look at is investment quality," says Russell Francis, a fee-only financial adviser in Portland, Oregon, who specializes in building bond portfolios for his clients. That means sticking with bonds - or bond funds - that sport ratings of AA or above.

You can stick with a mutual fund or exchange-traded fund and let someone else vet the portfolio. If you are buying individual bonds, dig deeper than the ratings. Read about the issuing authority and make sure that they aren't overextending on projects or pensions.

CHOOSE YOUR MATURITY CAREFULLY

Thomas McLaughlin, a municipal bond strategist with UBS Financial Services Inc., says the sweet spot is in the middle range. He is concentrating on bonds with between 5 and 15 years of maturity, on the theory that they will pull in bigger yields but avoid the extreme volatility of the longest bonds. You can build a "ladder" of various maturities so that you always have some money coming in to reinvest, and some longer term bonds capturing higher rates.

(Editing by Bernadette Baum)